Wed, Apr 1, 2015
A A A
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Opalesque Islamic Finance Intelligence

Featured Structure: Call Option using Set-Off By Nikan Firoozye, PhD

Tuesday, February 09, 2010

Options have value - it is one of the core concepts of modern finance. This optionality can be manufactured as in a financial instrument such as a derivative option or it can be embedded in mundane day to day choices (companies can choose to default, individuals can pay their mortgage in advance, we can skip a day at work, etc). Thus options are everywhere, some might not be very wise choices and others might be totally unknown to us since they might expire without ever being exercised.

Specifically in finance, options have been monetized (i.e. a significant part of the industry is built on how to price them) and they are typically used to transfer risks from an issuer to a buyer/holder of that instrument. It is this risk transfer (as opposed to risk sharing) that precludes Islamic financial institutions from using these instruments. Much of the pricing/valuation of options centers around payoffs, so a financial transaction might not be a derivative in a puristic sense but its payoff might be identical.

Arriving at a call option through debt set-off is a case in point. Also known as muqaddasah, a debt set-off will necessarily observe AAIOFI shariah standard number 3, which states that setoffs are possible as long as: 1) they involve the same counterparties (e.g., I owe you and you owe me) and 2) the notional is the same and 3) the maturity is the same. These can even be made contractual. There is also some leeway if notionals are different and maturities are different. Here we profile the basic set-off.

In the diagram above we see the cashflows for a call-option. This structure has been used for Principal Protected Commodity Notes (just adding on a separate SPV with murabaha to synthesize the zero-coupon bond) by some large commercial Saudi banks and super-large continental European banks. The procedure is as follows:

  • Investors puts up $C (call premium) at t=0, which is supplemented with the Murabaha (effectively borrowing $(K-C) strike price less call premium-worth of a commodity at time t=0).
  • The commodity is sold on the open market to raise $(K-C).
  • The premium and proceeds of commodity sale with total value of $K are invested in a Bay-al-Salaam contract.
  • This Salaam contract is used as collateral (through a "pledge") for the Murabaha and recourse to the SPV is limited to this Salaam contract.
  • At maturity, the commodity is delivered and will be sold (on the open market) under a separate wakala arrangement.

Now there are two possible scenarios at maturity t=T
  1. Commodity price P > K the strike. Commodity is delivered into salaam, sold, proceeds are used to cover the monies owed in murabaha, and the remainder $(P-K) is paid to investor.
  2. Commodity price P the strike. In this case, the commodity is delivered and sold, but proceeds cannot cover the murabaha and the bank will exercise its recourse to receive the value from the proceeds of the salaam sale. The SPV is wound down with no further recourse.

Effectively, investor receives max(P-K,0) at time t=T, the payoff of a call option.

Some see the combination of Salaam and Murabaha as a suspect means of preventing forward sales, since they clearly can synthesize a forward (although scholars rarely try to limit this). If we move beyond these possible objections, then combining Salaam, Murabaha and Debt Set-off, allows for a wide variety of payoffs. Certainly AAOIFI standards alone show that debt set-off is allowed and it can be contractual. Here, the salaam and the murabaha have the same maturity and same notional, so what is owed on one can be used to offset the other by contract with no further recourse or implications. The SPV and pledge allow it to take place from an English Legal perspective.

Your feedback and comments are very important to us, please feel free to contact the author via email.



Article Link

<< Go Back to Archive

Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing


  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. Other Voices: Does the hedge fund industry benefit society?[more]

    This article was authored by Don Steinbrugge, Chairman of Agecroft Partners, a US-based global consulting and third party marketing firm for hedge funds. It is no secret that the hedge fund industry is viewed negatively by a la

  2. Private credit comes into focus for investors[more]

    Bailey McCann, Opalesque New York: As investors look for a way out of the low yield/no yield environment, private credit is becoming an increasingly attractive asset class, according to a white paper from Bayshore Capital Advisors. Private credit has grown steadily since the financial crisis as

  3. Other Voices: The role of diversification in CTA portfolios[more]

    2014 brought a resurgence of managed futures strategies, or CTAs, which performed very well as a whole, outperforming all other hedge fund strategies. However, a closer look reveals that there was a wide range of performance, or return dispersion, across managers. The bottom line? Not all CTAs

  4. Neuberger Berman unit buys 20% stake in activist hedge fund Jana Partners for $2bn[more]

    Komfie Manalo, Opalesque Asia: Neuberger Berman’s unit Dyal Capital Partners bought a 20% stake in activist hedge fund firm Jana Partners worth $2bn, WSJ.com reports. The deal comes as activi

  5. Hedge fund launches fall again, $1bn funds found to outperform even smaller hedge funds[more]

    Komfie Manalo, Opalesque Asia: The number of new hedge fund launches fell again in 2014, the third consecutive year of decline, while fund liquidations saw their first drop since 2010, according to the latest HFR Market Microstructure Industry Report released by industry data provider HFR. Acc

 

banner